Professor Cole's Finance Blog

A couple of days ago, the Wall Street Journal published an article detailing a major and still-unresolved problem in the "Hope for Homeowners"--the Department of Housing and Urban Development's program designed (supposedly) to help homeowners who are "upside down" or "underwater" on their mortgages, i.e., who owe more on their mortgage(s) than the current value of the mortgaged property. According to the WSJ, only 95--yes--95 mortgages have been refinanced under this program. Hope for Homeowners was originally implemented under the Bush administration but has been repeatedly reworked under the Obama administration in hopes of providing some relief to the troubled U.S. housing market, so it is truly a "bipartisan" disaster.

Moody's economy.com estimates that as many as 16 million mortgage-holders--about one in three of the approximately 50 million households with a first mortgage--are currently underwater. These borrowers are often ineligible for $75 billion from the TARP that the Obama administation "diverted" to the Home Affordable Mortgage Program, another part of the administration's Making Homes Affordable program, which was announced back in March 2009 and has seen approximately 360,000 trial loan modifications started and more than 100,000 loans modified under the program. (Keep in mind that approximately 250,000 homes have been going into foreclosure EACH MONTH during 2009 to get an idea about how "successful" even this program is, although it is a home run when compared to Hope for Homeowners.)

The big problem explored in the WSJ article, and previously discussed on this blog, is the program's failure to address the problem of second liens--typically home equity lines of credit used to finance loan amounts above the typical 80% loan-to-value of conforming mortgages that can be securitized by Fannie and Freddie. Market participants estimate that more than half of all underwater first mortgages are collateralized by properties encumbered by second liens. The market value of these second liens is virtually zero, except for the fact that the second-lien holders can "hold up" refinancing of the first lien by demanding full repayment (to which they are contractually entitled). Hope for Homeowners requires that second liens be "extinguished" before the first mortgage can be refinanced, but second-lien holders want to be compensated for their claim, and Hope for Homeowners, until now, has not provided for such compensation. (Currently, there is a plan to offer some minimal compensation to second-lien holders, but unlikely to be enough to ge their cooperation.)

The vast majority, estimated at eight in ten, of these second liens are held by the financial institution that originated the first mortgage, and most of these are held by the Big Four of commercial banking--Bank of America (which bought Countrywide), Chase (which bought WaMu), Wells Fargo (which bought Wachovia) and Citi (which originated enough crap on its own and didn't have to go out and buy trouble)--each of which received at least $10 billion in TARP funds, although all have repaid, or are planning to repay, those funds.

In aggregate, commercial banks hold more than $600 billion in home equity loan balances outstanding, and most of these are held by the Big Four banks. Because these loans are designated as "held to maturity," they are recorded at book value and do not have to be "marked-to-market." This is the crux of the problem because recent transactions indicate that these loans are worth in the range of ten cents on the dollar, or about $60 billion--implying that there are about $540 billion in imbedded losses that these banks have yet to recognize, and cannot afford to recognize. Think of this as "ground-hog day" for the banking industry, taking them back to September 2008, should they be forced to write down these loans. Each of the Big Four would be insolvent and require yet another massive bailout by Uncle Sam, but, worse than that, probably would bring about another financial panic where no financial institution would trust or lend to another financial institution. This is what happened after the Lehman Brothers failure last September, and could happen again any day this September (or October or December.) It's going to happen--but just a matter of when . . . .